This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

Pru brain trust sees economic progress in 2013, despite 2012 ‘dichotomy’ and uncertainty; reiterating it’s riskier to be out of the market than in it

In an annual New York event, Prudential brings together some of its smartest leaders to help educate the press on its annual outlook for the markets and the economy.

The good-news consensus for 2013 at Tuesday's gathering? An improving worldwide economy, helped by higher housing prices in the U.S., a likely increase in corporate earnings, lower gas prices, the lack of a hard landing in China and sustained growth in many emerging markets, greater stabilization in Europe and continued actions by the world’s central banks. “My guess is that the worst of the financial crisis is behind us,” said speaker Ed Keon (left), managing director for Quantitative Management Associates.

The bad-news possibilities? Some drag on the U.S. economy from higher taxes, potentially disruptive elections in Italy and Germany, the increasing chance of inflation and continuation of “policy dysfunction” in Washington.

How to invest at such a time? Quincy Krosby, chief market strategist for Prudential Annuities, said, “when you have markets driven by [government] policy, it’s impossible to figure out when (is the right time) to get into or out of the markets.” She argued that in such an environment, there’s more risk in “staying out of the markets than being in them” and said that the “barbell” investment strategy she recommended last year at this time remains pertinent: be defensive on one end of the investing barbell, but take on more risk at the other end.

What kind of government policy are we talking about? “Over the last 16 months, there have been 326 eases or stimulus measures by central banks” throughout the world, Krosby (right) said. There may well be additional such central bank moves as inflation shows signs of returning. “Inflation pressures are building in emerging markets,” she said, a trend she expects to show itself in the second half of 2013.

Saying that we’re currently experiencing the “great muddle-through” in the economy described by Keynes, Krosby also voiced worry that we may not be totally out of the woods. “There may be dislocations hidden under the financial structure,” a phenomenon she called “tremors” that we can’t see right now, so she recommended “taking care of downside risk in both fixed income and equities.”

The "tremors" Krosby referenced are affiliated with the work of Hyman Minsky, the late economist whom Krosby said explored the relationship between risk and the markets (Minsky was dismissed by many mainstream economists, but his explanation of how markets react to speculation and cheap money and euphoria by coming to crisis and then contracting—the "Minsky moment"—gained much credence at the time of the 2008 financial crisis).

John Praveen, chief investment strategist for Prudential International Investments Advisers, half-smiled when he called 2012 "an interesting year," and expressed the hope that 2013 would also be interesting.

He noted the "dichotomy" evident in 2012 where there were weak economies worldwide but stong markets, suggested that European Central Bank President Mario Draghi "could have been man of the year" for keeping the eurozone in one piece and said that some of the factors that drove the markets higher in 2012 were "still in play."

Among those factors, said Praveen (left), were the heightened level of activity by central banks; he said he wouldn't be surprised to see more rate cuts by the ECB and the Bank of England—"maybe this Thursday," meaning January 10—and by the Bank of India in the first quarter.

He expects to see further stability in Europe this year, despite elections in Italy and Germany; expects some improvement in GDP in Europe (slight), Japan (some) and in the emerging markets. With valuations "not so rich" in world equity markets, Praveen also expects corporate earnings will improve in all three of these areas.

About that dysfunction in Washington, Mike Lillard, chief investment officer for Prudential Fixed Income, said we can “expect the budget battles to continue in Washington." Those battles will only produce "small deals" prefaced by "lots of gamesmanship." Moreover, those small deals will also be time-limited: "they'll need to be reviewed again in three months or six months."

That kind of environment, he said, "offsets a lot of the positive news in the economy," presenting his group's expectation of GDP growth of 2% in the U.S., 5% in emerging markets and 3% globally. As for other Washington action, Lillard said he expects the Fed to "continue to buy bonds throughout the year" if the unemployment rate only comes down slightly; if the jobless rate stalls, "the Fed will be buying through next year." As for potentially more bad news, he also said it's “hard to see getting through the year without further actions by the ratings agencies” on U.S. debt.

So where should an investor look for returns when Treasury yields are so low? Lillard (right) continues to like high-yield debt, arguing that American companies won’t be spending “big” on capital expenses or on hiring. In the high-yield area, he expects "defaults at 2%," so BB-rated high-yield bonds returning 5% and BBBs returning 6% "are still attractive."

In addition, "we like U.S. money center banks, since tight regulation will keep risk at a minimum," and within the structured products area "likes AAA-rated CLOs with floating rates," which he said are yielding 140 basis points over LIBOR. That floating rate feature of collateralized loan obligations will be particularly appreciated by investors if inlation rears its ugly head.

What About Retirement?Following the other speakers’ macro dissection of past and possible future moves in the markets and economy, George Castineiras brought the discussion back to the individual investor, specifically retired and soon-to-be retired Americans.

Castineiras (left), who heads Prudential Retirement’s Total Retirement Solutions division, presented his outlook on the retirement industry. While he called the outlook for the retirement industry “very positive” and argued that Social Security “won’t go away” despite many Americans' belief to the contrary, he also painted a sorry picture of the state of retirement preparedness.

While 10,000 boomers are now turning 65 every day, he said that “6,000 are unprepared” and that the median balance in defined contribution plans is only about $25,000. While saying Social Security will remain in place for a long time to come since it’s a “very big income source” for retirees, he also pointed out that 71% of current Social Security recipients are getting reduced benefits because they retired too early to get their full benefits.

That piece of data is just one instance, he said, of showing that “Social Security is grossly misunderstood,” and suggesting the paramount role of and opportunites for advisors in guiding plan participants to make good decisions. “Participants want someone to do it for them,” he said.

Four major factors are driving the challenges in retirement planning for individuals and the entire country, Castineiras argued:

1) The demographics of the American population

2) The need for retirement income, which also “won’t go away”

3) The rise in longevity, as evidenced by the fact that “50% of the babies born in the U.S. this year will live to 100”

4) The findings of behavioral finance, which explains why some retirement plan participants find it difficult to make the right decisions: The fear of making a wrong decision is stronger than the fear of making no decision.

Traditional defined benefit plans, which Castineiras said “produced the right outcome” for workers, continue to shrink, with only 15% of private employers offering such plans.

“They’re going away,” he said, and many of those that remain are “going off the balance sheets” of companies that still offer pension plans.

Castineiras said the Pension Protection Act of 2006 had produced a better outcome for many participants through promotion of the “the autos” in ERISA-governed retirement plans—automatic enrollment, automatic escalation of contributions and automatic default investment alternatives, or QDIAs. However, while Castineiras believes the workplace is the “right place” for participants to save for retirement, mentioning specifically the fiduciary responsibility of plan sponsors, he believes nevertheless that to improve retirement preparedness, “new engagement models are needed.”

Castineiras also warned that the sheer amount of money in retirement plans—some $13 trillion in employer-sponsored plans; and some $16 trillion over all—makes the industry a target of would-be deficit-cutters in Washington. “Retirement dollars are second only to preferential tax treatment” for employer-provided health insurance, he said, in terms of so-called “tax expenditures” which might come into play should a broader tax reform discussion become part of the federal deficit negotiations.